PROBLEMS
1. The gasoline excise tax is an example of a benefit tax: people who use the highways pay
for their upkeep through the tax. In what ways does the gasoline tax meet or fail to meet
the criteria of horizontal and vertical equity? Can you think of a way of improving the
horizontal or vertical equity of the gasoline tax, without abandoning the benefit principle?
Solution: This is more of a discussion type of question. Gasoline excise tax fails to meet
the criterion set for the vertical equity because those users pay in proportion to their
usage irrespective of their income levels. But it meets the horizontal equity criterion. If
the government imposes a gasoline excise tax based on the level of consumption, then it
could improve the vertical equity. Other answers are possible.
2. Using supply and demand diagrams, show i) the incidence, and ii) the change in quantity,
when excise taxes are imposed on goods in the following sorts of markets:
a) Demand is elastic; supply is inelastic.
b) Demand is inelastic; supply is elastic.
c) Demand and supply are both elastic.
d) Demand and supply are both inelastic.
What generalizations can you make after studying these four cases?
Solution: Refer to diagrams in the following pages.
a)
b)
c)
d)
3. In each of the following cases, state what the incidence of the tax is if the “flypaper”
theory is correct, and what the incidence is if the tax is wholly or partly shifted. How
does the shifting of the tax change your evaluation of the horizontal and vertical equity of
the tax?
a) the corporation income tax
b) the property tax
c) the sales tax
Solution: People who have never studied economics almost always believe in the
flypaper theory of incidence, which holds that sales taxes are borne by consumers,
4. The text shows that a tax that changes economic behavior may actually improve
efficiency, if there was inefficiency in the absence of the tax. In each of the following
cases, i) design a tax that would improve efficiency, and ii) evaluate the tax in terms of
the criteria of equity:
a) The national savings rate is excessively low because usury laws have kept interest
rates low and because many people distrust banks.
b) The air over major American cities is polluted because people are allowed to emit
wastes into the atmosphere free of charge.
c) Municipal water supplies are running short because of overuse.
d) Too many unmotivated students are taking up space in local, publicly supported
colleges.
Suggested Answer: This is a discussion type of question. Student answers will vary.
a) The government could impose a tax on consumption that would decrease
consumption and increase savings. Without any other provisions this tax could be
5. (harder) Draw a supply and demand diagram for a good with ordinary, moderate
elasticities of supply and demand.
a) Show how an excise tax is represented by a new curve on the diagram.
b) Show on the diagram how the output, market price, and price to the supplier have
been affected by the introduction of the tax.
c) Identify the incidence of the tax on the diagram.
d) Identify the tax revenue on the diagram.
e) Identify the burden of the tax on the diagram, and show how the burden is divided
between buyers and sellers.
f) Identify the excess burden of the tax on the diagram.
Solution:
a) The supply curve shifts up by the amount of the tax—in this case, $100. The figure
above shows such a shift by the movement from S0S0 to S1S1.
DISCUSSION QUESTIONS
1. The president has decided that some taxes should be reduced, and he turns to you for
advice. What taxes would you recommend cutting, and why?
Suggested Answer: Student answers will vary. They should provide justification for their
tax-cut recommendations. Related concepts: tax burden, flypaper theory of incidence,
equity, ability-to-pay.
2. How would you evaluate i) the federal personal income tax, and ii) the federal payroll
tax, with respect to
a) horizontal equity?
b) vertical equity?
c) efficiency?
Suggested Answer: A comprehensive personal income tax with few loopholes scores
3. As the text states, some state courts have found that the financing of public schools
through the local property tax is unconstitutional because it deprives children in poorer
districts of equal educational opportunity.
a) Do you agree with this finding?
b) What sort of tax system can you think of that might meet the courts’ objections?
Suggested Answer: Controversy has arisen over whether local property taxes are an
equitable way to finance public education. Local property taxes provide the main source
4. Under the American system of fiscal federalism, the federal government makes grants to
state and local governments, mostly in restricted form, that is, for use on particular
projects. These grants have been subject to various criticisms. Some argue that no grants
should be made; instead, the federal government should cut its tax rates, and if the states
wish to make expenditures, they should raise their own tax rates. Others say that the
grants are justifiable, because they help to compensate for income differences between
the states, but they should not be restricted; states should be able to use them for anything
they wish. Still others argue that the only problem with the grants is that they are too
small. Outline and defend your position on this issue.
Suggested Answer: Student answers will vary. Supporters of large grants see state
governments as more flexible and closer to the people. They also view the states as
5. Some people criticize the federal income tax for allowing too many deductions and
exclusions. The consequence, they say, is that people distort their economic behavior in
order to take advantage of the tax loopholes. Assess each of the following “loopholes,”
and show why you think it should or should not be retained:
a) The interest on municipal bonds is not taxed.
b) The interest component of home mortgage payments is deducted from income, so that
no taxes are paid on it.
c) Property owners are allowed to deduct “depreciation expenses” from their income,
even though the value of their property may have increased, not fallen.
d) Medical expenses above a minimum are deductible.
Suggested Answer: Student answers will vary. Every tax loophole encourages particular
patterns of behavior and favors particular types of people. Furthermore, because most